Proceedings of the Standing Senate Committee on
National Finance
Issue No. 43 - Evidence - October 31, 2017 (afternoon meeting)
OTTAWA, Tuesday, October 31, 2017
The Standing Senate Committee on National Finance met this day at 2:15 p.m. to continue its study on the Minister of Finance’s proposed changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved.
Senator Percy Mockler (Chair) in the chair.
[Translation]
The Chair: Honourable senators, welcome to this meeting of the Standing Senate Committee on National Finance.
[English]
My name is Senator Percy Mockler, from New Brunswick, and chair of the committee.
I wish to welcome all of those who are with us in the room and viewers across the country who may be watching on television or online.
As a reminder to those watching, the committee hearings are open to the public and available online on the Senate website at sencanada.ca.
At this time I would like to ask the senators to introduce themselves.
Senator Black: Doug Black, Alberta.
[Translation]
Senator Pratte: André Pratte from Quebec.
Senator Forest: Éric Forest from the Gulf region in Quebec.
[English]
Senator Frum: Linda Frum, Ontario.
Senator Oh: Victor Oh, Ontario.
Senator Marshall: Elizabeth Marshall, Newfoundland and Labrador.
[Translation]
The Chair: I would also like to acknowledge the clerk of our committee, Gaëtane Lemay, and our two analysts, Sylvain Fleury and Alex Smith, who are here and provide support to the committee.
[English]
Today, our committee continues its special study on the proposed changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved, changes that the Minister of Finance proposed during the summer of 2017.
In preparation for the trips in Western Canada and Eastern Canada that the committee will be going on soon, it was suggested that the Parliamentary Budget Officer be invited to comment on his recent Fiscal Sustainability Report 2017.
[Translation]
I would like to thank Mr. Fréchette and his team for accepting the committee’s invitation. We are very glad you are here. From the Office of the Parliamentary Budget Officer, we have with us today Jean-Denis Fréchette, Parliamentary Budget Officer, Mostafa Askari, Deputy Parliamentary Budget Officer, and Chris Matier, Senior Director, Economic and Fiscal Analysis.
I will now ask Mr. Fréchette to give his presentation, after which, we will move into the question and answer portion.
Jean-Denis Fréchette, Parliamentary Budget Officer, Office of the Parliamentary Budget Officer: Thank you, Mr. Chair and honourable members of the committee.
[English]
Thank you again for the invitation to appear and discuss our Fiscal Sustainability Report 2017, which I believe could help provide some context for the committee’s upcoming fact-finding missions to Western and Eastern Canada.
[Translation]
Since 2010, the Office of the Parliamentary Budget Officer has published an annual fiscal sustainability report on the federal government’s finances. This year marks the first time that we expanded our analysis to include a fiscal sustainability assessment by province and territory.
[English]
The report provides information on which provinces and subnational governments see their government debt growing continuously or not as a share for the economy.
For senators who defend regional interests, as well as giving voice to minorities and underrepresented people in Canada, this new analysis may prove to be useful to engage in discussions with some of these groups in various regions of the country.
[Translation]
Mr. Chair, my team and I would be pleased to answer any questions you may have. Thank you.
[English]
The Chair: Thank you.
Senator Marshall: Thank you for being here this afternoon. I want to focus on the part of your report that addresses Newfoundland and Labrador, the province that I represent. Your report came out in early October. We also received reports from the provincial auditor general and from the Canadian Employers Council during October.
Basically, their comments are very similar to yours. The auditor general has made a number of comments. He has indicated that the deficits aren’t sustainable. He also said that Newfoundland generates more revenue per capita than any other province. It also spends 21 per cent more per capita than Saskatchewan, which is the next highest spender.
The Canadian Employers Council issued a report called Another Way Forward. Radical is probably not the right word, they are suggesting that government reduce its taxes by $590 million and reduce spending by $1.1 billion. They think that will help to put the province on the road to recovery.
The auditor general’s report was received as we generally receive auditor general’s reports, but the government reacted, especially negatively, to the report. My question is: Was your report discussed with the Government of Newfoundland and Labrador and, if so, what kind of feedback did you get?
Mr. Fréchette: Your question is very apropos. Following the publication of our report probably two provinces reacted a lot on it, of course, Newfoundland being one and Alberta. I will ask Mr. Askari to answer the questions from stakeholders in Newfoundland.
Mostafa Askari, Deputy Parliamentary Budget Officer, Office of the Parliamentary Budget Officer: On your question about consultations with the government, before we published our report, way ahead of time, we consulted with all the provinces and provided them with the data and the methodology that we were using to do the calculation. They were fully aware of what we were doing and how we were doing it.
Following the report, we haven’t really had any discussion with the Government of Newfoundland, but other stakeholders contacted us, wondering exactly how we did the study and what were the consequences of this kind of assessment for Newfoundland.
One of the things that I mentioned to a number of stakeholders is that, yes, there is certainly a gap between spending and revenues in Newfoundland, but the underlying problem in Newfoundland is the loss of population. Newfoundland is losing about 1 per cent a year of its population. When you lose population, especially most of them who would be working age population, that significantly affects the economy of the province. Our projection for Newfoundland is growth in the neighbourhood of 0.1 per cent to 0.2 per cent, or essentially a flat economy. That by itself is a huge shock to the economy and the fiscal situation in Newfoundland.
Senator Marshall: Businesses in Newfoundland and Labrador are really very concerned about the proposed tax changes which we’re considering and studying now. Newfoundland and Labrador has the highest taxes per capita in the country and the proposed tax changes that are coming in now will make them higher still.
Do you see any glimmer of hope at all for the province?
Mr. Askari: We are estimating the gap that exists for Newfoundland is about $2 billion a year on a permanent basis. That $2 billion will increase by the rate of growth in nominal GDP. It has to, in order to bring the finances of Newfoundland back to a more stable situation.
It is a $2 billion gap. How would you fill that gap? It depends on how you want to do it, whether you want to do it on the spending side or revenue side, or whether you can convince the federal government to provide more transfers to Newfoundland.
Those are the three sources for the province, but the magnitude is $2 billion. This is close to 6.5 per cent to 7 per cent of the GDP of Newfoundland. It’s a big hit.
Senator Marshall: It’s a big hit because it is $2 billion and the population is half a million. It’s a big gap.
Senator Black: Gentlemen, thank you very much for being here, and thank you for the extremely helpful work that you do.
I’m a senator from Alberta, and I am interested that you have had ongoing conversations with Alberta. Based on what I have read in your report, I’m glad you are having ongoing conversations with Alberta.
The statement that has kept me awake for too much time over the past weekend is “Current fiscal policy in Alberta is not sustainable over the long term.”
Can you be clearer?
Mr. Askari: That’s correct.
Senator Black: That was rhetorical. Really, my question to you is: I accept that as your view.
That is deeply concerning, given that Alberta is one, if not the only, engine of the Canadian economy. I read that you’re saying the engine is going to stall.
Mr. Askari: One of the issues with Alberta is that the economy is growing at a relatively healthy pace, based on our observations. What we see in Alberta, as far as the fiscal situation is concerned, is a huge gap between the sources of revenue internally in Alberta, excluding the transfer from the federal government. Its own-source revenue in Alberta as a per cent of GDP is the lowest in the country relative to other provinces. On the spending side, actually Alberta has relatively high spending relative to GDP.
The math there is very clear. If you have own-source revenue that is very low, because obviously everybody knows taxes in Alberta are low and there’s no sales tax, the numbers reflect that. That gap is an issue if it continues over time.
That’s how we look at it. This is the current structure. If we maintain that structure over a long period of time, how would that affect the finances of Alberta? What we see is that the deficit will accumulate and it will feed itself because the government then has to borrow money. That will lead to a rising debt level relative to the GDP of Alberta.
Despite the fact that Alberta probably has one of the youngest populations in the country and the economy, as I said, is at a relatively healthy pace of growth, these underlying fiscal issues will certainly affect the finances of the Province of Alberta over time.
Senator Black: Thank you for that. I agree. What does Alberta need to do to fix that problem?
Mr. Askari: We won’t provide policy advice as a matter of principle. It’s not really within our mandate to provide policy advice. Mathematically, the gap is about 4.6 per cent of GDP in Alberta, which I believe is close to $12 billion to $14 billion.
That gap needs to be fixed on a permanent basis. Whether you do it on the revenue side or on the spending side or as a combination of both, those options are open to any government in Alberta. In our conversations with a number of stakeholders in Alberta one of the things they always ask about is, “What about the resource revenues in Alberta?”
The issue there is that oil prices certainly are down relative to what they were a few years ago. The way we do our calculation is that we assume the revenues at the end of the medium term, that is 2021. What about the revenues that are generated in Alberta relative to GDP that will keep the ratio constant over time?
If resource revenues happen to come back to a more healthy pace, then the assumption means that other sources of revenue will have to give. In general, however, we don’t really see much prospect, at least at the moment, for oil prices going back to $150 and $200 levels. We don’t think that our calculations and estimates are unreasonable in that sense.
You can’t really rely on resource revenues to save the province from this fiscal issue. Something else has to be done policy-wise within the province to deal with this.
Senator Black: If this were not a provincial government but your home or household, what you would do?
Mr. Askari: I would never compare a household with a government. Those kinds of comparisons are not really reasonable in the sense that households have different objectives and different tools. Governments have different objectives and tools as well. It’s very difficult to compare those two.
Senator Black: Very well managed. Thank you very much.
[Translation]
Senator Forest: From the outset, it’s important to manage finances as any responsible head of household would. Without likening a government to a household, I would say that both need to be particularly mindful of the common good, however small or large it may be.
In your report, you indicate that Canada’s current long-term fiscal policy is strong enough to implement tax reductions amounting to 1.2 per cent of GDP. You even project that, in the long term, the federal debt could be eliminated in 40 years, which seems a rather ambitious goal, but nonetheless desirable.
What really troubles me is the situation facing subnational governments. The municipal world is one I am very familiar with, be it at the territorial or provincial level. Your projections with respect to subnational infrastructure are much less optimistic. Currently, you estimate that tax increases or spending reductions amounting to 0.9 per cent of GDP would be needed in order to stabilize the budget. Is that reflective of the current economic situation? I’m thinking, in particular, about the more than $120-billion investment in infrastructure. Under the federal government’s policy, infrastructure investment is being fast-tracked, especially by municipalities, which are accelerating their investment in order to take advantage of various subsidy programs. They are running up their debt with a very limited tax base. Did you assess the impact of major federal programs on municipal, territorial or provincial entities? Your analysis puts the federal government in a fairly good position. However, territorial, provincial and municipal governments are struggling to catch up. Programs are being made available to them, so, from their standpoint, they have no option but to take advantage of those programs, in order to secure the infrastructure they need to prepare for the future and meet their needs going forward. Consequently, they feel compelled to invest, resulting in larger deficit growth for each of these entities. Is there a causal link? Is this a set of economic conditions that, on the one hand, are very troubling for subnational governments and, on the other hand, comforting for the federal government?
Mr. Fréchette: Thank you for the question. First, I would like to be reassuring. You mentioned subnational governments, such as Quebec. In our report, when we talk about Quebec, we refer to all governments, meaning municipal governments, indigenous peoples, and so on. It is important to understand that, right now, we are creating a current picture projected in time, in 75 years, 90 years. Let me use the example of Quebec again. You’re absolutely right with respect to all the subnational governments in Canada: there is a 0.9 per cent gap, $18.7 billion. Quebec has no gap. Quebec is viable with all its governments. This is not a question of circumstances. The current economic situation is viable. It is possible for other subnational governments to restore the balance. In Ontario, the gap is very small. It’s almost within the margin of error. We could restore the balance. I’m trying to be reassuring as I answer your question. We must not worry too much about the fact that subnational governments have to inject money.
Senator Forest: You know, there are a lot of creative accounting practices. For example, when we look at the gasoline excise tax rebate in Quebec, which used to go directly to municipalities, but now is taken by Quebec, it forces municipalities to borrow. They repay the principal and interest over the term of the loan. This is not ideal for sound management. Municipalities used to directly receive prorated amounts and were able to invest those amounts. There’s some more added value in infrastructure now. We are forced to bear those costs because this transfer is taken. Every province and territory has its own way of doing things. In my experience, although the priority is not to invest today and to rename such and such a street, since the program exists, I will go ahead because I will be looking for 60 or 70 per cent in subsidies. I am significantly increasing my debt ratio. In the long run, this will clearly have an impact.
The Chair: Do you have any comments, Mr. Fréchette?
Mr. Fréchette: It is possible that we did not see it for all the provinces. I am not saying that it will not happen, but we do not see it for all the provinces. The current situation is as stated in the report. It must be understood that any other changes in tax policy, whatever it may be, will lead to an imbalance in our model of long-term projections.
To go back to the previous comment made by the senator from Alberta, it is important to understand that Quebec, compared to Alberta, has a much higher tax rate. This is one of the reasons why Quebec is financially viable. The province’s own-source revenue is higher than Alberta’s, since much of Quebec’s tax room is taken by the provincial government.
[English]
Senator Oh: Thank you, witnesses.
The Department of Finance Canada releases a long-term fiscal protection each year. How and why does your projection differ from that of the Department of Finance Canada?
Mr. Fréchette: This is Mr. Matier’s favourite question, I’m sure.
Chris Matier, Senior Director, Economic and Fiscal Analysis, Office of the Parliamentary Budget Officer: It might be one of my favourites. In the Finance Canada projection there are a couple of differences in terms of the accounting basis. I believe their projection is done on a Public Accounts basis, so the same framework seen in budgets and fall economic statements. Ours is on national accounts or a government finance statistics basis, which is a slightly different concept. Probably the biggest difference is that we look at the entire government sector in Canada. We’re looking at the provincial and the local governments, Aboriginal governments, as well as the public pension plan. We want to have the complete picture. I believe that in 2012 our Auditor General at the time recommended that Finance Canada prepare similar long-term projections for the provincial governments, but the government declined that recommendation.
In terms of the overall results that we see, at least compared to Finance Canada’s last report in 2016, released in December, I believe, they are very similar in terms of their federal outlooks. There might be some differences in terms of the speed at which the federal debt-to-GDP ratio declines, but in a qualitative sense both would suggest the federal fiscal structure or policy is sustainable over the long term.
Senator Oh: Are there any other comments?
Mr. Matier: To follow up, we anticipate that Finance Canada will release its next long-term report this December. At that time we can provide a more detailed comparison, along with our assumptions and results. We can produce a report on that.
[Translation]
Senator Pratte: Clearly, you are doing an extremely useful exercise. Now, there is a little something that bothers me, because these are very long-term scenarios. Everything is very smooth, everything is going very well, because there is no economic shock. What scares me a bit is when we see conclusions that the finances of the Government of Canada are viable, that it could afford to increase spending or reduce taxes by $24 billion, or 1.2 per cent of GDP, and that it would not hurt its viability. It makes me jump a little. I understand what you mean, but the reason we do not want the Government of Canada to increase its spending by $24 billion or to reduce taxes by the same amount is that, if there were an economic shock or a sudden rise in interest rates, the government could end up in a very troubling situation. As you said yourself, compared to last year, this 1.2 per cent was 0.9 per cent. However, the review of the interest rate projections resulted in a substantial change. We must be extremely careful with the interpretation of those data.
Mr. Fréchette: You have to be careful, as we have indicated in our report. These are not forecasts; they are long-term projections of a current situation. We are taking a photograph now. Everything you said is perfectly true. Here are the policies in effect and, if you make projections, nothing changes. No external shock, no internal shock. There is no temptation to pilfer from the till. The government is viable for this entire period. What is interesting — as you mentioned — is that, compared with our report last year, where we were at 0.9 per cent, we are now at 1.2 per cent of GDP. Let me repeat two interesting examples in Alberta and Quebec. If we had our analysis before the oil shock, everything would have been different. Quebec is another good example. I was misquoted, as many politicians sometimes are. I was quoted as saying that, in Quebec, austerity had led to viability. That is not what I said. I said that Quebec’s financial rigour resulted in Quebec becoming viable again as you take Quebec’s picture now. You are quite right; you understand the situation exactly. These are not forecasts and projections, they are about stimulating discussions in Parliament in order to determine whether the budgetary policy should be maintained or not. Is that tempting or not? The role of parliamentarians is to use the tools they have been given to have discussions with other levels of government all across Canada in order to find out their spending intentions.
Senator Pratte: Does this comparison of the financial viability of the Government of Canada, compared with that of provincial and territorial governments, lead to the conclusion that there will be an imbalance between the two levels of government that, a few years ago, used to be called the fiscal imbalance?
Mr. Fréchette: That seems to be the case. It used to be said that the federal government had the money and the provincial government spent it. That is actually the case, as Mr. Askari mentioned. The provinces with aging populations must provide health care, whereas the revenue is with the federal government. So there is indeed a kind of imbalance between the ability to generate revenue and the duty to provide certain services, especially in health, education, and so on. That scenario is based on demographic change over time. We know full well that some provinces have more of an aging population than others. In the younger provinces where the tax base is a little smaller, it opens up the whole debate about the imbalance and, frankly, about equalization payments. That is the case in Manitoba. Equalization should have been able to change their viability level, but since they have relatively strong economic growth, reasonably strong but not strong enough, they get no equalization. So that can be problematic in the long term.
Senator Pratte: Thank you.
[English]
Senator Andreychuk: I want to pursue the report you put out.
Do other countries approach long-term projections in the same way as you do so that we could compare other countries as well as inter regionally?
Mr. Matier: Yes, other countries provide similar long-term reports. There are differences in terms of the length of the time horizon and the sector of government that’s being produced. Ideally that would be the best way to make comparisons of debt-to-GDP ratios and current fiscal policies if we had this sort of uniform framework.
Senator Andreychuk: Just picking up on Senator Pratte, the shocks may not be our shocks but international shocks, and you’ve gone through that. It would be interesting to see projections elsewhere and whether those projections are in line with your projections.
Mr. Matier: I also believe the IMF, on occasion, provides international comparisons. I’m not sure if they are at the very long-term horizon, but they are on a total government basis that helps to make those comparisons.
Senator Andreychuk: Maybe I could ask a few questions on Saskatchewan, obviously. We’ve dealt with Alberta. You’re pointing out that the growth rate of the population will slow and you’re indicating that it’s not sustainable at the moment.
Did you factor in anything to do with the Aboriginal population, its population growth in the province and some of the success stories of new models in the Aboriginal community sustaining the future of Saskatchewan? I don’t see one word about Aboriginal in there.
Mr. Matier: No, we haven’t explicitly taken those projections into account. We are relying on Statistics Canada’s demographic projections, so to the extent that they’ve incorporated those differences in fertility rates and life expectancies they would be reflected in our projections.
You are correct. We do not have them separated out in our projections.
Senator Andreychuk: You seem to have relied heavily on the population decrease from migration, I would say, if I read you correctly. There is also an aging factor. There is a movement from less rural, which causes real service problems. When the population decreases, what level of service can they expect? How can it be supplanted elsewhere, like losing some hospitals, et cetera?
The whole problem is: How do we maintain a level of service? That is the program side. The other side is: Where do we get the money to do it? That has become increasingly important to me as I see the government federally introducing very good programs, except when you dig down you’ll see that the delivery mechanisms, whether justice or health, et cetera, are provincial.
I don’t quite see whether you factored this in as a trend. I see it as a trend more and more. We’re back into that cycle of putting more on to the backs of the provinces that then put it on to the municipalities.
Mr. Matier: We haven’t looked at the very regional implications within a province of migration, demographics and population aging that is going on. It’s really only reflected for us across provinces where you have out-migration and in-migration varying quite a bit.
We do flag, in this report and in previous reports, the federal government’s contribution to sort of national programs such as health care and some social assistance that are definitely projected to be declining over the long term. Taking health, for example, in several of our charts we see the federal contribution through the Canada Social Transfer, which was previously between 20 per cent and 25 per cent, definitely shrinking through time as basically the aging population goes through the health care system.
As it stands now, the current program is structured to only grow in line with the economy. Again, if the federal government were to maintain its contribution to provincial health spending through the CHT, there would have to be additional growth, and likewise for the Canada Social Transfer. That growth annually is limited in aggregate to 3 per cent. Again, provinces are probably facing spending pressures in excess of 3 per cent annually. The federal contribution to these programs through the CST, Canada Social Transfer, would also be declining through time.
Senator Andreychuk: I have a final question. You’re saying the overall federal picture is sustainability in the long term, subject to all the other factors that were put in.
Is there anywhere, when we look at burden sharing, we can see how much of today’s debt load would burden the next generation and the next generation? That should worry people with children, grandchildren and great-grandchildren.
What I grew up with is that I should use the resources at our disposal and not unduly burden the next generations. I thought that was one of the underpinnings of our Canadian federal system. Have you factored in those kinds of things, or is it strictly figures that you use to say it’s sustainable, figures that you were able to elicit?
I have this fear that people will think it’s okay to spend by reading your report, and that bothers me.
Mr. Matier: We’re not able to say what is the correct or optimal amount of indebtedness that the government sector should have, but our projections are very much in line with the thinking about intergenerational equity. Really, what we’re trying to estimate is basically not adding on additional indebtedness relative to the size of the economy to future generations. That’s what we mean by a stable debt-to-GDP ratio.
The main issue, as you pointed out, though, is the imbalances between the Government of Canada and the subnational governments. Coincidentally in our framework our overall conclusion is that the total government sector in Canada is sustainable, but it’s only because the room at the federal level is offsetting the unsustainability at the provincial level.
On a very aggregate, global basis we would say no, we would not be passing on under current policy additional indebtedness to future generations, but depending on which province you live in and which subnational government you’re subject to, that would be quite different.
Senator Frum: Could you talk about the importance of productivity growth in your projections and how it is changing in one direction or another can have an impact? Given that this committee is now studying the change in tax policy, I’m thinking specifically that all experts have said it will discourage investment and growth by private corporations. Can you talk about the impact that would have?
Mr. Matier: In our long-term projections we’re assuming essentially that productivity growth will converge back to the average level we’ve seen over the last 35 years, approximately, or around 1.1 per cent annually in terms of growth.
The impact that has on fiscal sustainability really depends on the current structure and how the programs are tied to that type of spending. Our assumption is that in any changes we see in terms of productivity, such as if the economy is growing faster, the government would maintain its spending relative to the size of the economy. There is not a gain in the fiscal sense that you have a faster growing economy, your spending relative to the size of the economy would decline, and that would give you fiscal room. Essentially, we maintain that same ratio going ahead.
As an example, in our report to the federal government, if productivity growth were to increase, I believe by 25 basis points or 50 basis points, the amount of fiscal room would increase from 1.2 per cent of GDP to 1.9 per cent of GDP. That is fairly significant.
The savings you really generate there is that, relative to the rate of interest you have to pay on your debt, your economy is growing faster and the wedge between what you’re spending and what you’re bringing in gets smaller. That’s typically where the savings are generated.
Senator Frum: You have also said these projections presume no significant shock to the system. In the terrible event of the termination of NAFTA, I presume the projections will go in the garbage, or what happens?
Mr. Matier: They are very long term. It’s likely that with such a kind of shock there would definitely be a transition period, a temporary downturn and the possibility of a permanent impact on growth rates or on levels going ahead.
As Mr. Fréchette mentioned, we are not really trying to do forecasting. This is basically to give you not the best case but the most reasonable case for planning. If the results that you’re seeing under current policy now are raising red flags, that should tell you something. Any of those sorts of downside shocks would make things worse going ahead.
Senator Marshall: My questions now concern the federal government because we are looking at proposed federal tax changes. In your report you’re saying the current fiscal policy at the federal level is sustainable over the long term. I was a bit surprised when I read that because with Budget 2017 we know that we’re approaching the $1 trillion mark with regard to debt. Furthermore, we know from December’s report last year the Department of Finance is projecting deficits until 2055.
There is this pressure to deal with the deficit, but that doesn’t seem to be a concern of yours because you’re saying what’s being done now is sustainable over the long term. Then you go on to say that there is lots of room there. You’re saying that the government could increase spending or reduce taxes. That goes against what’s happening now. Even though you’re saying there’s room to reduce taxes, we all know that the federal government is on a mission to increase taxes.
Can you reconcile your report with what is happening in the Department of Finance?
Mr. Askari: As Mr. Matier mentioned, this is a long-term scenario and not a forecast, first of all. Whether taxes decrease or increase right now over the short term, at the end of the medium term, which is 2022, we assume the tax burden at the federal government level, for example, will remain constant over the next 75 years. This means the revenues will grow at the same rate as the nominal GDP, so the tax burden will remain constant.
Now, things may happen. Taxes may go up or down or shocks may happen on both sides, positive or negative. Again, this is a scenario. You’re assuming, on average, that the economy will stay on the growth path of 1.7 per cent in real terms and about 3.7 per cent in nominal terms, and that taxes will grow at the same rate as the nominal GDP. All those things you mention in the short term would not really affect that kind of calculation.
The other point you raise is whether the deficit going on for another 30 years would be sustainable. Yes, it would be sustainable as long as the deficit increase is small enough that the resulting debt increase would not actually be at the same rate as the GDP growth. Debt to GDP will either go down or remain stable. You can have a small deficit for a long period of time and still have a sustainable fiscal structure because your debt-to-GDP ratio is not increasing. That is the anchor you are using, and it is an anchor used in all international studies that do the same thing.
Senator Marshall: When I look at the work that you did for the federal, provincial and territorial governments, I see some reference there to pension plans. I know some of the provinces have unfunded pension liability. Based on what you say in your report, even with those unfunded pension liabilities there is no concern.
Mr. Askari: Those are all counted in our calculation of spending and revenues. They are all underlying those. Those assumptions will cover all those expenses or potential revenues, whatever they are.
Actually we only look at, explicitly in our case, the CPP and QPP, which are other programs. We look at their sustainability and the conclusions that those two programs are sustainable. Anything else within provincial government expenses are already covered by the assumptions we are making.
Senator Marshall: You’re saying that what is happening now in the federal government is at a sustainable level, and if the government is out there raising taxes then they can also increase expenditures as long as they keep their GDP ratio where it’s at now. Is that what you’re saying?
Mr. Askari: That’s the anchor we are using. As long as that debt-to-GDP ratio remains stable over a long period of time, we define it as a sustainable fiscal structure.
Senator Marshall: Also, there are a lot of assumptions in the report, aren’t there? In order for you to come up with your projections you’re making a lot of assumptions.
Mr. Askari: Yes, we are, but in doing this kind of a study you have to make certain assumptions to provide that scenario. Those assumptions are not really unreasonable in a sense. They’re not much different from the historical experience or what we have seen in the past for these jurisdictions.
We are not assuming a significant increase in revenues over time or a significant decline in spending or anything like that. From our perspective the assumptions we are making are reasonable assumptions. Yes, you may go off in some of these cases, but over a long period of time, if those are maintained at the level we are assuming, this is the result we get.
I need to mention here one thing we mention in our report. None of this result over 75 years will actually happen because you can’t really see a province having 300 per cent debt or the federal government actually eliminating its debt in the next 30 years. Those things will not happen because the reaction of the government will be to change that process.
What we are trying to show here is that especially for those jurisdictions that have a fiscal gap, as we mentioned, there is an issue they need to deal with right now or over the next few years. Otherwise, the future will not look very good.
Senator Marshall: We will get some shocks. We don’t know what they are, but Senator Frum mentioned NAFTA. Everything won’t go chugging along wonderfully.
Senator Black: Building on what my colleagues Senator Frum and Senator Marshall had to ask and given that it’s Halloween, I do find this all a bit scary.
I looked at a report that I believe came out from you folks this morning. I saw your projections that the real GDP growth is to slow in 2018 to 1.9 per cent, dropping this year from 3.1 per cent. In my view that is a dramatic drop in GDP growth in one year. Then you went on to say that nominal GDP is on average $2 billion lower per year over 2017 to 2022; a snapshot today.
If you build in the possibility of a failure of NAFTA, as Senator Frum has asked; if you build in tax reform in the U.S.; and if you build in the fact that Canada seems unable to build pipelines to either the Atlantic or the Pacific coasts, what is the outlook for Canada?
Mr. Matier: That’s a good question. It is difficult to answer very well.
In our current economic outlook we have not factored in a complete withdrawal from NAFTA or breakdown in those talks. As well, we haven’t incorporated any U.S. tax reform or infrastructure spending. It’s a bit of hand waving, but we have assumed the negatives and the positives would cancel each other out.
We don’t explicitly have projections in there of the impact of pipelines not being built, but our investment in mining, engineering, and all of that would be captured through changes in oil price futures as well. We can’t provide you with an estimate of that impact, but we can say in our outlook we have oil prices staying very low and we have investment in that area.
Again, it has rebounded, but we will not see those kinds of levels of investment that we saw in the past in that specific sector.
The Chair: Mr. Fréchette and the PBO officials, thank you very much for accepting our invitation and sharing your comments and your views.
For the second part of or meeting today, we have invited the Canada Revenue Agency. Thank you for accepting our invitation to be here to share information. It will be educational to some extent and will give us some highlights of what is coming.
The committee would like to know about the implementation of what we call a reasonableness test with respect to income sprinkling. We are also interested in the current Income Tax Act and would like practical examples on intergenerational transfer, taxation of passive income, taxation of dividends and revenue sprinkling. Honourable senators, the witnesses from CRA are here to discuss these issues and to answer our questions.
From CRA, we welcome Geoff Trueman, Assistant Commissioner, Legislative Policy and Regulatory Affairs Branch, and Stéphane Prud’homme, Director, Reorganizations Division, Income Tax Rulings Directorate.
Mr. Trueman, I have been informed that you will make a short presentation and then we will move to questions.
Geoff Trueman, Assistant Commissioner, Legislative Policy and Regulatory Affairs Branch, Canada Revenue Agency: It is a pleasure to be here this afternoon with my colleague Stéphane Prud’homme. I will keep my opening remarks short. I know you have heard significant testimony on this issue over recent weeks. We will be happy to answer questions on it so that we can respond to your concerns.
We’re here to discuss the CRA’s interpretation of the provisions in the Income Tax Act for private corporations that relate to changes recently proposed by the Minister of Finance, in particular the sprinkling of income to family members from such corporations. We understand that you would like us to address how the CRA will administer the proposed changes to the Income Tax Act, as proposed by the Department of Finance, which is aimed at further addressing concerns with income sprinkling if those proposals are to be enacted.
As you know, the measures were included as part of a consultation package on Tax Planning Using Private Corporations announced by the Minister of Finance on July 18, 2017. The deadline for submitting comments under the consultation was October 2, and the Minister of Finance announced on October 16 that the government would, among other possible changes, simplify the income sprinkling proposals to ensure that family members who meaningfully contribute to a business will not be impacted.
From the testimony you have heard you are fairly aware that income sprinkling is generally defined to occur where the income of a higher income individual is diverted to a lower income individual, often a family member, so that it can be taxed at a lower level. This effectively allows individuals in the highest tax brackets to potentially have a portion of their income taxed at a lower rate of tax.
Currently, certain income tax rules are in place to curb income sprinkling. For example, when a business pays expenses such as salary, those expenses are required to be reasonable in order to be deductible. As well, there is a special tax on split income that applies to address income sprinkling with minors by imposing flat top-rate taxation on sprinkled income, including dividends from private corporations and certain income that is derived through trusts or partnerships from a family business.
It is proposed that for tax purposes dividends paid to an adult family member should be reasonable, such that they reflect contributions made by that family member to the business, whether in the form of capital invested or work performed for the corporation.
In accordance with the current audit practices at the CRA we would apply the proposed rules in a fair, consistent and sensible manner based on the facts and circumstances of any particular case we may be faced with. The review of salary expenses, for example, paid to a family member already forms part of the audit continuum at the agency when dealing with private corporations under an existing reasonableness test. These tests are found throughout the Income Tax Act, and we have a long-standing history in applying these rules in a fair and consistent manner.
To ensure that Canadian businesses know what to expect, the CRA is working with the Department of Finance to prepare meaningful guidance for business owners and their advisers to ensure they understand how the CRA will apply the proposed reasonableness test and in what circumstances. This guidance will include detailed examples of circumstances in which the CRA will and will not question a taxpayer’s determination that the amounts paid are reasonable.
I would like to note that we will continue working with our colleagues at the Department of Finance to ensure that the CRA is ready to administer the proposed income sprinkling measures including its reasonableness test within their policy intent. We have a long-standing relationship with Finance built on collaboration and open communication which will ensure that we are able to do so.
My colleague and I will be happy to take questions from the senators this afternoon.
The Chair: Thank you.
Senator Marshall: Mr. Trueman, in your opening remarks you talked about your current audit practices and applying the proposed rules in a fair, consistent and sensible manner. Then, apparently, there is some sort of guidance. It says, “This guidance will include detailed examples.”
What kind of guidance is provided to the auditors at CRA? What is the process? Who makes the decision on reasonableness? Can you provide us with an overview of the process?
Mr. Trueman: Yes, I would be happy to do that. There are probably a couple of steps here. When Finance came out in July with the package there was draft legislation associated with income sprinkling. Then following the October announcement, Finance indicated their intention to simplify some of those proposals.
In terms of working with colleagues at the Department of Finance, our first step would be to prepare guidance that we would try to release as shortly after the introduction of legislation as possible. The first step is to provide guidance that would be available out there to the tax community and business practitioners so they would have an opportunity to see the kind of examples and the factors we would look at in applying reasonableness tests.
We do that in certain other areas of the act where a reasonableness test exists already. Then we would follow that up with internal guidance to auditors based on best practices and again looking at the types of factors to consider, always stressing that these tests need to be applied on the facts and circumstances of a given situation. There is no one answer or right answer that suits all, but we try to make sure that people evaluate all the factors and circumstances.
Senator Marshall: We know the reasonableness standard will be used for income splitting, but what other instances are there? From what you’re saying you had lots of experience in applying reasonableness standards. Give us an example of some other cases with a reasonableness standard.
Stéphane Prud’homme, Director, Reorganizations Division, Income Tax Rulings Directorate, Canada Revenue Agency: The first provision that comes to mind is in paragraph 20(1)(c). This provision allows a taxpayer to deduct interest on borrowed money, but it is only a reasonable amount of interest payable that is deductible.
There is another example at section 67 of the Income Tax Act. The provision in section 67 is a general limitation applicable throughout the act. A taxpayer can claim a deduction in respect of an expense, only to the extent that such expense is reasonable in the circumstances. That’s why Mr. Trueman was mentioning that applying similar provisions which call for the application of a reasonableness test is not something new to us.
Senator Marshall: How many people would you have applying the reasonableness standard? Would it be all your auditors?
Mr. Prud’homme: For example, these two provisions are probably of interest and applicable in most cases. We’re talking about deduction of interest paid on borrowed money to earn investment income or business income, and we’re talking about any deduction claimed by a taxpayer with respect to section 67. It would cover most taxpayers in Canada.
Senator Marshall: Would most of your auditors be performing these reasonableness tests?
Mr. Prud’homme: It would be part of the normal work involved in an audit.
Senator Marshall: How do you manage it? If you have 100 auditors applying the reasonableness test, how do you know it’s consistent? What sort of monitoring or reporting is it?
For example, say I’m one auditor and there are a lot of disputes. How do you manage it and how do you monitor it?
Mr. Prud’homme: I think you’re referring to consistency here. Consistency in the application of the provisions of the Income Tax Act is very important. The fact that CRA will provide guidance early in the process will certainly be something that will contribute to having consistency in applying these new rules. Of course, audit activity will be monitored to ensure that consistency is achieved.
Senator Marshall: How do you monitor it to make sure it’s fair and consistent?
Mr. Trueman: Our colleagues in the compliance branch would be placed to give a specific answer to that question. I apologize that they’re not here today. You have the technical side of the tax stream with you here today.
Within our area of the agency we’re responsible for what we call National Technical Capacity Building Forums. We provide clear guidance and instruction across the agency to auditors on how to interpret certain provisions of the act, which are often the more complex provisions, to ensure that we have a consistent base of knowledge among the auditors throughout the agency so that there is a common understanding.
Auditors would also be aware of the ongoing jurisprudence in a particular area and the experience they build up over the years in terms of working in the audit function.
Senator Marshall: The concern of some of the witnesses is with regard to the fairness of the reasonability test. I’d like to know exactly how you protect the fairness people are looking for when you apply the new rules to them.
Mr. Trueman: We can certainly commit in terms of the guidance and instruction we offer. If you would like more information on the quality assurance work we do within the agency, we could provide that as well.
Senator Marshall: Are there policies already drafted? Are you saying there are policies for the taxpayer and policies for the auditors?
Mr. Trueman: As the Department of Finance develops the draft legislation, we would work with them to provide the initial guidance that would be made available to the tax filers or the tax community out there. It would accompany the draft legislation so that there is a good understanding of how it’s intended to work.
Senator Marshall: But it is not developed yet.
Mr. Trueman: No, not currently, because the proposals themselves are still under development at the Department of Finance.
Senator Pratte: Practically all the tax experts, chartered accountants and other tax practitioners who have come before us have told us that they believe this reasonableness test will be very complicated to manage and to interpret. They believe it will lead to years of litigation and the CRA will have difficulty working with it. They seem to believe that it’s very complex and very complicated.
I’m not a tax expert. I don’t think why they seem to think that, but having worked with the draft legislation as it was on July 18 that’s what they seem to believe.
Do you have any comment? Is there any reason to think that this is more complicated than the reasonableness tests that you already work with?
Mr. Trueman: We certainly appreciate the commentary from the tax community and small businesses. What we have seen from Finance is a willingness to go back and take a second look at these provisions to determine if there is a way to simplify those measures and to ensure that where a meaningful contribution is made to the business these are not the individuals intended to be scoped into the ambit of the rules.
Having said that, I certainly want to make sure I give colleagues at the Department of Finance time to continue to refine the proposals.
Can we work with a reasonableness test? I think we can. The guidance will be very important in terms of looking at the key factors in determining these things. As we have said, there are reasonableness tests out there already. It provides a bit of flexibility as well when you look at the example earlier about the cost of borrowing money.
If I have a large, well-established business with substantial assets and cashflow, I may be able to go to the bank and get something close to prime rate. A small business starting out that does not have those benefits will probably go in and pay a much higher rate currently. That’s the type of thing auditors take into account. They recognize those different situations. We would seek to apply that same sort of approach in terms of looking at a reasonableness test as well.
Senator Pratte: Something was pointed out to us as being maybe more complex than others. The government acknowledged that they would recognize in the reasonableness test past contributions in respect to previous labour, capital or risk contributions.
Of course, this raises the whole question of whether the small business has kept documentation on a past contribution that was maybe 10 or 15 or 20 years ago, knowing that it was not in the Income Tax Act at the time. There was no way to know that this documentation would have been needed.
Do you foresee how that would be applied, at all?
Mr. Trueman: Certainly, in terms of what was enumerated in the July proposals, we have a multi-factor test that looks at four key items, if I remember correctly, including the functions performed, the assets contributed and the risk assumed in previous remuneration.
In terms of were we to be in an audit situation, it would be important to recognize that in an area such as prior remuneration you’re right that there might not be the same level of books and records available going back over an extended period of time. As one of the factors, it is something that an auditor would have to take into account and to do so in a constructive manner.
Mr. Prud’homme: Again, the government announced on October 16 that it will work to reduce the compliance burden of establishing the various contributions of family members. We expect that these changes will facilitate the administration and the compliance of the proposed rules for both the CRA and the taxpayers.
Senator Pratte: And for the CRA.
Senator Frum: In fact my question follows on what you just said, Mr. Prud’homme. I want to ask about compliance around income sprinkling in particular.
There was a witness who came before this committee last week that owned a small manufacturing company and was a tax lawyer that has practised for 30 years. His name is Robert Kepes, and I would like to read you something he said in his testimony:
The burden of proof in CRA audits and tax appeals is always on the taxpayer. The spouse will have to prove two things when it comes to income sprinkling: first, their contribution to the business; second, what would an arm’s length party have paid them? It’s difficult to imagine the level of evidentiary proof required to satisfy a CRA field auditor of what an arm’s length party would have agreed to pay for the contributions of the spouse or adult children. If the auditor is not satisfied then the only avenue is a lengthy and expensive appeals process. These rules are designed to foster tax appeals and litigation.
Can you comment on those words?
Mr. Prud’homme: The only comment I would have is, again, that we indicated the CRA has experience in dealing with reasonableness tests with respect to other provisions in the Income Tax Act.
The other point that needs to be mentioned is that, of course, the Canadian tax system is a self-assessing system. Normally, when a taxpayer takes a tax position, the taxpayer needs to support that position and basically keep books and records to support such a position.
That being said, when we talk about reasonableness I think there is always a range of reasonableness. We mentioned earlier in the process that we would interpret these rules, apply these rules and administer these rules in a consistent, fair and measured manner that would be in line with the intent and the purpose of the provisions.
Here the clear purpose of the provision is to stop income sprinkling. We’re talking about a rate play, if I can say, where dividend income is basically diverted from a higher income earner to a lower income earner. I would think we would basically apply these proposals in that sense.
Senator Frum: Can we agree that these measures will result in more audits and more tax appeals because they increase the complexity of the system? Can you comment on whether or not CRA is prepared to handle the increased workload that will inevitably arise from this, and whether or not Canadians can expect to have their appeals heard in a timely fashion?
Mr. Trueman: I would start by saying that this would be part of the regular audit or compliance function. There is not an intention that there would be additional audits or new audits created as a result of this. This would be part of the compliance practices that a small business would have to follow and that an auditor would be responsible for administering.
Senator Frum: In the appeals process it’s inevitable that if you add more rules there will be more appeals.
Mr. Trueman: We are talking about reasonableness tests. Sometimes when new rules come into play in the tax system there is a period when it takes a little while to sort through them. You have an initial transition period. Then there is an understanding and a working ability within the tax professionals, small business and audit communities, quite frankly, in terms of coming to a reasonable outcome on the rules.
I would hope that these would form the part of the audit spectrum, but there would not be a specific focus on them per se.
Senator Black: I also wish to continue on the line of questioning which is being developed by my colleagues. Let me start by saying that I appreciate your reasonableness and your clear willingness to continue to serve, in the face of what I would suggest is real adversity.
I want to say, by way of preamble, that everyone is entitled to their opinion. We heard from a tax expert this morning, and you undoubtedly have seen the testimony of this morning. In summary, Mr. Éric Brassard of Quebec indicated that in his view the task which will fall to your agency under passive investment introduces, in his language, a level of unprecedented complexity. It is beyond complicated, he suggests; it’s unmanageable. Professor Jack Mintz, in respect of income sprinkling, suggests, and it’s only his suggestion, that the ability to set a reasonable test in respect of income sprinkling is in his view not possible.
Now I juxtapose that with your suggestion, under the very able questioning of my colleagues, that we wanted to understand how you were to come up with a reasonable test. You indicated that you have experience in that. You have experience around, you told us, cost of borrowing money. What is a reasonable cost to borrow money? In ascertaining whether an expense is reasonable, is my expense for entertainment as a lawyer in downtown Calgary reasonable? You have developed tests to determine that.
I suggest to you that determining the contribution of a spouse on a family farm in rural Alberta is very different from borrowing money or quantifying gasoline expenses. How do you possibly think that you can use your existing protocols on something which is so fundamental to our economy and so personal to the family?
Mr. Trueman: Thank you for the question.
On the first one, in terms of the comments from Mr. Brassard concerning passive income, you are correct in that respect. That proposal was not accompanied by any draft legislation when announced in July. What we saw in the most recent announcement from the Minister of Finance was a broad proposition for a certain exemption level and a couple of other changes.
We still do not have any actual draft legislation on that. On that one, I would certainly wait to see what the actual proposal is. I do understand the complexity issues there in terms of tracking various amounts over time and where we create segregated accounts. Certainly that’s understood.
On the reasonableness test, I don’t mean to underplay that it will be a challenge. You’re right. Providing my example of borrowed money is probably one of the easier ones to look at, for sure. Some of the more challenging ones will be those where you have a strong imputed labour component, such as on a farm where various family members will make different contributions over time.
You’re right. That will be a challenging area for us. I would hope, though, we would be able to do so in terms of examining the operations of the farm over time, looking at the role the spouses play or children play, and comparing and contrasting that with the work of hired help on the farm as well, to get a benchmark for that. It will be one of the more difficult ones but, again, we’re hopeful that we can fall within the bounds of reasonableness in that area.
Mr. Prud’homme: When we’re referring to the guidance we are preparing, the proposals will subject dividends to the tax on split income if the amount of those dividends exceed, as you mentioned, what would have been paid by a corporation dealing at arm’s length, considering four criteria. These criteria are functions performed, assets contributed, risks assumed, and previous remuneration.
For each of these four criteria, the guidance will provide some factors that may be considered in establishing these contributions. With respect to functions performed, we will consider the nature of the tasks performed, the hours required to complete the task, and the competitive salary/wage for the task in relation to similar businesses. We will also look at the education, training and experience of the individual, and the particular knowledge, skills or know-how of the individual. Those are just an example.
Senator Black: With complete respect, you can’t know how foolish that would sound to a farm family or a family that runs a hardware store in Lethbridge, Alberta. What you have just said is completely impractical. That’s the problem that we’re having with these.
I respect that you’re there to serve, stand up and salute. I get it, but what you are suggesting cannot possibly be done in a fair way. We’ll leave it at that. We have a different point of view. You need to know that what you said, while I respect what you said, just doesn’t work in the real world.
Senator Andreychuk: I’m sharing Senator Black’s passion. I come from Saskatchewan. Senator Black has eloquently said it, in terms of farms and small businesses. You can’t possibly measure one farm from crisis to crisis and how they run. It isn’t what the run. It’s how they run their families, as well as how they run their businesses.
That goes to the point that the government wants innovation. They want small start-ups. I read these stories, and I wonder how they come up with these ideas to run these businesses. It’s their ingenuity to overcome day-to-day crises that did it.
Reasonableness is not the test. It’s not like lawyers who have a profession or an accountancy. Every farm is different. You can say every law firm is different but, no, they have certain rules. You say that you’ll check it against the hired man, et cetera, but that wouldn’t be a correct test.
A child on a farm gets ill and someone has to take the child two hours to the nearest hospital. Someone else pitches in. It’s a free-flowing system trying to stay above water. Are you going to ask them to keep logs about this and justify the crises on a day-to-day basis? Reasonableness is in the eye of the beholder. Is it a subjective test or an objective test? I don’t think you can find objective criteria.
Shouldn’t you go back to the minister, your bosses or whomever you talk to, and say this will compound an issue? It will sap the innovation of everyone in the country, small start-ups and businesses. Don’t you think we can do this cheaper and better in a different way and get out of this reasonable test?
It is still a problem in criminal law. We’ve been at it since we started. It’s less complicated over the years than running a business that fluctuates according to international standards. Farmers are now with telephones trying to sell their wheat and canola somewhere in the world. They will have to do this bookkeeping for what purpose?
Mr. Trueman: In terms of the dividend and income sprinkling proposal in particular, we’ve seen a willingness to reconsider. We’ve seen the wording from the Minister of Finance in terms of the focus on making a meaningful contribution to the business. It will be important to see what the revised proposals look like before we get too far ahead.
I do think reasonableness will continue to be part of the administration of the Income Tax Act, however, but I certainly understand where the thought is coming from for sure.
Senator Andreychuk: I wouldn’t take out reasonableness in other areas but in this one, because of the way it was structured, is it reasonable to the family unit? You don’t really know what the law will be anymore than we do. We have an indication, and you’re supposed to administer this in weeks. It’s not reasonable to you, I’m suggesting.
Mr. Trueman: We’ll work as quickly as we can.
[Translation]
Senator Forest: I have a two-part question. The first part is of a general nature and deals with what we have just been saying, that we have heard from many witnesses, in the light of the Minister of Finance’s major proposals for tax reform on those same four points: intergenerational transfer, income sprinkling, the reasonableness test, passive investments and capital gains exemptions.
The changes made over the past few weeks seem to alleviate some of the concerns. The big question is how the Revenue Agency will interpret the rules to implement those measures.
In the coming weeks, the Senate Committee on National Finance will invest more than $300,000 in consulting Canadians from east to west. You will have the opportunity to hear what those people have to say. We have already heard from many people in Central Canada.
If we had the rules of implementation from you, I think we could do a much better job of consulting. If we were able to tell the public how the Revenue Agency intends to implement this, we could do a more effective job.
The legislation has not yet been implemented. We understand your position, but the fact remains that, if we could use the public funds to conduct relevant consultations from east to west and if, subsequently, the legislators could make changes starting with the objectives, it would be more consistent.
This is a sort of heartfelt appeal from me to you. Even if it is a bill, bill in capital letters, it would be useful to be able to pass on more information to people on how to apply the rules based on the interpretation of the four major criteria. I think the entire institution of Canada would be a winner, because there would be real consultation. We would be proactive and that would make the investment much more worthwhile.
This was my first and more general question. Now my second question, which is more specific, is about intergenerational transfers.
I worked in the field of public administration of a small town, a small local government. In my experience, the number one criterion that should guide us is fairness. We must respect the laws that govern us and make fair decisions. What I do for Senator Moncion, I have to do for Senator Pratte. I absolutely cannot understand how, if I sell to a third party, I have an excessively large capital gains exemption, and if I sell to my family, I do not have that exemption.
In Quebec, we have a piece of legislation that protects farmland. We do not protect agricultural activity. We protect farmland. Prior to the amendments to address this inequity, farmers in Quebec did not sell their farm to a third party, they simply auctioned it off with the machinery, the land, and so on. Often, large corporations from major centres came to buy land from us in order to reduce phosphorus levels from manure spreading. It was completely anti-development. Right now, there is a renewal of acquisition by third parties.
How can we accept such a significant inequity between selling to a third party and selling to the family? We are talking about a very significant tax exemption. I cannot understand the government’s position to perpetuate this inequity between a transaction with a third party and a transaction with the family.
Mr. Prud’homme: That is an excellent question, Senator Forest. With respect to your first question, you mentioned the intergenerational transfer. At one point, in section 84.1, it was proposed to amend it. It was proposed to add a new general measure specifically against avoidance, in section 246.1, but this was withdrawn. However, consultations have been announced with respect to intergenerational transfer. The Department of Finance has stated its willingness to consult the tax community, families and entrepreneurs to address this issue that has existed for 30 years. Remember, the rules we have now have been around since 1985. So these different tax choices are based on tax policy decisions. These are decisions that our colleagues in the Department of Finance have to make. At the Canada Revenue Agency, we have been administering this piece of legislation unchanged for 30 years.
In relation to passive income, no legislation is currently proposed. With respect to income sprinkling, significant changes have been announced to streamline the proposals. So the Revenue Agency has played a preventive role, but it is very difficult, if not impossible, to issue guidelines in the immediate future, since the proposed tax legislation is still being developed. We are in daily contact with the Department of Finance. That’s how we have addressed the important changes announced in July.
With respect to intergenerational transfers, you have discussed the various tax treatments available in the event of a sale to a third party compared to a sale to a holding company in which a child participates as a shareholder. There will be tax implications if the capital gains exemption is claimed or not. Committee members are aware of this. Tax policy decisions have led to the various treatments. In terms of tax policy, it was decided that the capital gains exemption could not be used to extract a corporation’s surpluses in a non-arm’s length context. This rule has been part of the legislation for a very long time. On October 19, the government made it clear that it would be consulting on this, despite the fact that the amendments to section 84.1 have been set aside.
Senator Forest: Between you and me, do you think this 30-year-old rule is fair?
Mr. Prud’homme: I’m not here to give my personal opinion. My role is to apply the law. I will let my colleagues from the Department of Finance reassess their fiscal choices if the need arises.
Senator Forest: We could help you reassess those choices.
The Chair: I would like to make a connection with Senator Forest’s comments. Let me take the example you gave us about section 84.1. I would like you to give us an example using the following scenario: the sale is approximately $900,000, less than $1 million. The shares are sold to a third party, a corporation or a child. I would like you to forward this example to the clerk; no need to answer right away. Then you can tell us what the impact will be on the selling price and on the tax. I’ll leave that with you.
[English]
Senator Oh: Thank you for being here today.
Yesterday, I attended an informal round table in Casselman, Ontario, with our deputy chair about the proposed tax changes. One of the participants told me, “I would not like to be the officer from the CRA who tells the wife of a farmer that her contribution is not significant.” I could not agree more. In fact, I think your officers have been put in a difficult situation by being the ones who will have to implement these flawed changes.
My question to you is: How will your officers tell stay-at-home parents, for example, that they are not a significant contribution to their families’ collective wealth?
I personally find that this sends the wrong message and undermines the collective sacrifice and risk made by family-run businesses.
Mr. Trueman: Again, I’ll go back to the words that we’re looking to the Department of Finance in particular for that meaningful contribution to the family business, which will generally be some form of work in that business.
You’re right. It’s not always an easy test to apply, but it’s one that we will have to apply going forward.
Senator Oh: Are there any litigated test cases? Do you have any track record on how successful it is from your side?
Mr. Trueman: Is that in terms of reasonableness?
Senator Oh: Yes.
Mr. Trueman: And in terms of dealing with it on an ongoing compliance basis?
Senator Oh: Yes.
Mr. Trueman: As mentioned, it is part of most of the audit processes. In terms of looking at the reasonableness of salaries and wages, for example, it is an important facet of that. It is something that does form part of the audit continuum now and will do so going forward, quite likely, in this area of dividend and income sprinkling as well.
Senator Marshall: We have spoken mostly about income splitting and we really haven’t discussed passive income, but I wanted to ask you something again about income splitting.
We have been told that the government expects to raise $250 million annually from the income splitting proposal. Does the CRA have targets for revenue raising? There will be pressure on you now to come up with that $250 million.
Mr. Trueman: That revenue estimate would have accompanied the original proposal from the Department of Finance in July. We would wait to see what the revised proposals look like. I’m not sure what Finance would do in terms of their revenue estimate associated with the former proposal. I would think there may well be changes in that regard.
Senator Marshall: I don’t expect there would be changes, but I’ll move on to my next question.
With these new tax changes, for the first year will everyone be audited? How are you to implement the changes?
Mr. Trueman: No, there would not be an audit of everyone in the first year. These would be part of the small business audit program, but there would not be a specific focus on these rules alone.
Senator Marshall: How are taxpayers selected for audit? How will the taxpayers who are subject to these new rules be selected for audit? Then, could you also tell us the generic selection process for audit?
Mr. Trueman: Taxpayers would be selected for audit in a number of ways within the compliance branch. It could be a random sampling of audits. It could be certain characteristics that are looked at in any given year as part of an audit program, but we would not align resources with these new proposals to audit solely on that alone.
Senator Marshall: You wouldn’t take individual taxpayers who are now subject to these new rules, put them in a separate class and say, “Okay, let’s audit 10 per cent of them?”
Mr. Trueman: No.
Senator Marshall: You wouldn’t do that, okay.
When we first started the session this afternoon, we talked about the protocol and the rules for income splitting and where you were with regard to your development of policies. Where are you with the development of policies to cover passive income? That will also be, I would think, a complicated area for you to audit. What have you done in that area?
Mr. Trueman: In this area we would really be waiting to see what the eventual legislative proposals would look like from the Department of Finance. In the absence of proposed amendments to the act, we would not be able to develop an audit protocol or position on this.
This is one where the draft legislation has not been released, so we would wait to see what that looks like.
Senator Marshall: For both the passive income and the income splitting there is no protocol developed yet. Is my understanding correct?
Mr. Trueman: Certainly not on the passive income where we have had no draft legislation whatsoever. With respect to the dividends and income sprinkling when the measures were announced in July, we began to plan on that basis in terms of looking at those proposals. What we will do now is wait to see what the revisions are from the Department of Finance following their announcement in October.
Senator Marshall: Once the final decision is made by the Department of Finance, could we get a commitment from you to provide us with a copy of those protocols so we can understand how you’re implementing the new changes?
Mr. Trueman: We certainly recognize the importance of this issue and this is one where we would try to develop our guidance as quickly as possible to give a greater insight into our application of the legislation. We’d be very happy to alert the committee as soon as that is available publicly, for sure.
The Chair: Thank you, Mr. Trueman, you will provide that to the clerk, please.
[Translation]
Senator Forest: I have two questions. Let me take the example of income sprinkling. You have the daunting task of defining the rules of application that make it possible to achieve the goal. Does the reasonableness criterion come from the legislator asking you to verify this criterion? You have to make sure that there is no income sprinkling, that it is fair and that it achieves that objective. Are you responsible for defining elements of analysis such as the reasonableness criterion? I want to fully understand. I’m really new here and I’m trying to educate myself.
Mr. Prud’homme: Thank you for your question, Senator Forest. One of the objectives of the guidelines will be to provide examples that will tell taxpayers how the CRA intends to interpret those proposed new provisions. The examples are developed in collaboration with our colleagues from the Department of Finance because we want to ensure that we understand the tax policy underlying the new provisions. It is also important to understand that future guidelines will be developed as the Revenue Agency gains experience in applying the rules. We know that there is a spectrum when it comes to reasonableness. It is therefore likely that we will initially provide important examples for taxpayers to become familiar with the basic rules of the new provisions. As the agency, our colleagues in the tax community and the courts start interpreting and applying those rules, it will be possible to add examples to the guidelines that will help the agency to observe and apply them.
Senator Forest: I would like to share an observation that you can use to guide your thoughts in your free moments. You have the weighty responsibility of applying Canada’s tax policy. As we hear from witness after witness here, a consensus is becoming clearer and clearer, in my opinion. It seems to be time to do a complete analysis of Canadian tax policy. What do you think?
Mr. Trueman: That would be a good job for our colleagues at the Department of Finance. In general, they are responsible for tax policy.
Senator Forest: And you have to apply it. Is it appropriate for you to review the tax policy in depth, given globalization, demographics, the new economy that has ever fewer material goods, and more intellectual property? Could it be an issue for Canadian society?
[English]
Mr. Trueman: Certainly I think one of the most important things for Canada is to have that competitiveness in the tax system. You’re right. People will comment with all kinds of reviews and revisions in terms of looking at the act.
You can see one of the measures the government announced recently, simply in terms of the reduction to the small business rate included as part of the package in October. For example, there is a measure that would drive Canada to have the lowest small business rate in the G7 when fully implemented in 2018.
It’s probably important to remember some of the fiscal aspects as well that also form part of the package.
The Chair: Thank you very much.
Honourable senators, tomorrow afternoon at 3:30 p.m. we will be receiving the Honourable Bill Morneau, P.C., M.P., Minister of Finance, in the same location.
(The committee adjourned.)